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Summary

While the extent of income inequality is debated periodically, one rarely discussed aspect of inequality is its impact on the tax system. Given the nature of the U.S. federal tax system, changes in the distribution of income can have significant implications for who pays the taxes, how much they pay, and federal tax revenues. One common measure to characterize inequality or the dispersion of income is the Gini coefficient, which varies from 0 to 1. A Gini coefficient of 0 indicates that income is evenly distributed among the population (that is, everyone has the same income) while a value of 1 indicates perfect income inequality (that is, one individual has all the income). Between 1980 and 2004, the Gini coefficient for household income increased from 0.403 to 0.466 -- a 15.6% increase. The Gini coefficient for earnings increased by 22.4% from 0.331 in 1980 to 0.405 by 2004. Inequality has, therefore, increased over the past 25 years. The two major sources of federal tax revenues are the individual income tax and the Social Security payroll tax, accounting for almost 80% of total federal tax revenue. These two taxes have different tax bases, tax rates, and adjustments to income. Furthermore, the individual income tax system consists of the regular income tax and the parallel alternative minimum tax (AMT), which have different tax bases and tax rates. Consequently, changes in income and earnings inequality could have very different effects on different parts of the federal tax system. Many of the parameters of the regular income tax are indexed to inflation. Nevertheless, with income growing faster than prices and with rising income inequality, more income falls into higher tax brackets. Individual income tax revenues as a percentage of GDP, however, do not appear to be associated with rising inequality because the income tax has become less progressive through legislative changes as inequality has increased. The parameters of the AMT, however, are not indexed at all. Consequently, the amount of income and the number of taxpayers subject to the AMT will increase dramatically over time because of income growth and rising income inequality in the absence of legislative changes. The actual increase in AMT taxpayers has been limited because of a series of enacted temporary "patches." Although the maximum taxable limit of the payroll tax is indexed for average earnings growth, rising earnings inequality has pushed more and more of covered earnings above the limit. Thus, the proportion of covered earnings that is taxable has fallen over the past 25 years. This report will not be updated.

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